From the October 01, 2006 issue of Futures Magazine • Subscribe!

The liquidity mirage

The advent of easy online access to trading, whether in stocks, bonds, commodities or forex, has created the perception of price transparency and fairness.

Every organization, from government regulatory bodies to the exchanges and brokers, promotes electronic markets as more liquid, transparent and tighter in terms of spreads. Opportunity and product diversity is supposed to allow ordinary people, or the retail sector, to access as much market information as institutional participants and at nearly the same speed with just the click of a mouse, creating and promoting the ideal of a level playing field.

Indeed, some of their points are valid; however, they fail to grasp that within the 23.5-hour day of electronic trading, liquidity is not always ensured. There are no guarantees that the available price at any time of the day or night will be deemed fair by the individual trader — whether retail or institutional.

This has become more relevant through the last two years when the overnight moves in all electronic markets, whether in gold, corn or even forex futures, have at times been an astounding 5% or more. The driver behind these moves invariably is not news but the lack of sufficient liquidity to take the opposite side of the trade.

The U.S. exchanges in most instances have installed certain measures to deal with the liquidity mirage. These include limit price moves that automatically halt trading for a short period or the cancellation of certain transactions on the basis of a disorderly market.

LOW-TECH COMPARISON

To help understand how liquidity can appear to be there when it isn’t, let’s consider the North African or Middle East Souk. These are the market places of ordinary people and ordinary goods where bargaining between the supplier or vendor, and the buyer or customer, is considered quite normal.

The roles are simple and familiar. Generally, the customer approaches the vendor and asks, “How much?” A response is given, such as 1,000 dirhams, at which point the customer feigns shock and horror at the exorbitant price. After this little formality, the process of what we call price discovery begins. The customer suggests 200, at which point we now have a buyer and a seller. The only problem is how to agree the eventual price that will be deemed fair by both parties.

Should the customer at a later stage wish to resell the commodity he has just purchased, he will find that the original vendor will be pleased to take it off his hands for say, 200 dirhams. Being the only buyer, the customer concedes feeling perhaps a little aggrieved.

Herein lies the concept of value. What appeared upon purchase to be a good deal turned out later to be an inflated price; but in reality, the buyer was simply the victim of the liquidity mirage.

The open outcry exchange floors with their colorful-jacketed locals or independent traders and clerks have been the historic providers of liquidity. The locals have risked their own capital for the opportunity to vie for the opposite side of the business for short-term gain vs. the banks, brokers and commercials. These institutional participants have a longer-term horizon in the nature of their transactions and the local operating as a market maker facilitates and profits short term from the order flow. This helps to gauge the strength or weakness of the marketplace via multiple transactions, which moves the market in an orderly fashion. The market will move to where the greatest number

of buyers and sellers are satisfied for the given moment, thereby creating a sense of value.

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